Debt: The Good, the Bad, and the Ugly

A spaghetti Western title and a topic fit for discussion. What more do you want? I sincerely mean discussion because this is my blog, so you are reading what I think. But…I am always open to others’ experiences and viewpoints. I’m not always right. No surprises there. Always more than one way to skin the proverbial cat. Let’s get started.

I’m debt averse. My name currently holds two different debts. I have used credit cards for many years. I carried a company credit card (from my employer) since age 14 and a personal card since age 18. Neither has ever carried a balance.

Last year, Mrs. TFC and I unfortunately were stuck buying a house due to a tight rental market. We carry a 30-year mortgage at a 5% interest rate. I assure you; the house is well below our means. Not AT, below.

Why debt averse?

Last week I wrote about risk. You can read that here. I spoke to the potential upside and the potential downside. Generally, debt allows you to leverage your money. Leverage allows the purchase of college, real estate, or a business venture. All of which have the potential to generate significant value over the long term. That’s the upside.

Remember, the lender will come knocking even if the leveraged purchase doesn’t work out. Big trouble right now for kids paying big bucks for college tuition and not graduating. This means they carry the debt from school without the career path to support the payments.

Poorly purchased real estate works the same way. Assume I put $7,000 down on a $200,000 house during the 2021 housing boom. That house is currently valued at $190,000 because the market is cooling off. I’m now carrying a $193,000 note on a $190,000 house. Not good.

Banks are concerned with this scenario because if you fault on your payments, they lose money. And banks aren’t in business to lose money, be your friend, or do you a favor. Nope, they are responsible to shareholders.

That’s a potential downside of allowing low down payments. Allowing home buyers to leverage their money via house purchase with 3.5% or 5% down. That’s a 29x or 20x leverage respectively on your money. Wild…

Stress

Money problems weigh on your mental health and relationships. They are the top cause of divorce. If something happens to your income, debt collectors are coming. No sympathy from them. Minimizing or eliminating debt is GUARANTEED to be a weight off your shoulders.

If you have never been debt free, ask a debt free individual how it feels. And if you emulate their decisions and pay off your debts, but aren’t feeling any better about your situation, you can always borrow money again. Really a low risk, high reward strategy.  

Mathematical Lens

I’m nerdy enough to enjoy the numbers here. If I have a debt at 6%, I could pay the monthly minimum, invest the difference, and average an 8% return in the market. A 2% gain. Theoretically and mathematically accurate. However, Murphy’s law reminds us reality refuses to agree with theory when a given plan is constructed around a given theory.

Because I’m an odds guy, I consider debt with an interest rate below 3% worth holding for mathematical purposes only. You would be investing your debts in the market if you choose to hold them. Even many fixed income products are over 4% these days. The odds of returning greater than 3% over a multiyear period are high.

Interest rates between 3% and 5% are not so clean. This comes down to individual preference. The markets may have a couple bad years. That real estate investment could be off to a rocky start. I could see holding this debt if one invests aggressively over multiple years and knows the potential downside. Or if interest rates continue to climb and fixed income products reach 6%.

No one will ever fault you for paying off debt regardless of interest rate. For every math nerd thinking they are too smart for this concept, they risk the peace of mind that accompanies financial stability.

Anything with an interest rate above 5% is considered high interest debt and should be paid off. Debt can be consolidated, but fees typically accompany this move. If the debt is small, just pay it off to avoid the consolidation fee.

If you have significant loans with a multiyear payoff, compare overall payments of the higher rate versus the consolidation fees.

Good Debt

An investment into yourself with reasonable opportunity cost is good debt. Student loans are generally bad debt because students don’t graduate. And they aren’t bankruptable. Npr.org reports 40% of college students who start paying tuition don’t graduate. Highly inefficient.

Really bad return on investment. Not everyone is cut out for college and that’s okay. There are many paths to financial independence.  

If you can attend a college for a reasonable cost and achieve a diploma that will translate to an above average paying career field, it’s worth it.

Future nurses, keep it to 4 years at an in-state public university. Future CRNAs, all programs have reasonable pass rates, so find an affordable one.

Fortunately, CRNAs are paid well enough to account for more expensive programs or delays along the way. There is nothing inherently wrong with delays such as changing a major, but they are expensive.

Looking at all terminal degrees, any degree held by a CRNA has a respectable return on investment. High, but manageable opportunity cost. Student loans to become a CRNA – good debt.

To be thorough with good debt, I’ll add business ventures to good debt if they are calculated well. Way too much latitude here to give examples. These ventures can take off without debt, but it isn’t common. Use your discretion as to whether a particular avenue is good debt.

Neutral Debt

Neutral debt is a reasonable purchase with an interest rate below 5%. Mortgage debt comes to mind. I have more than a few posts about how real estate as a personal residence is NOT an investment, so don’t go overboard here.

Really, run the numbers. It’s like rentals, but without the income and the tax advantages. So…pretty terrible. And since they increased the standard deduction to $27,700 for a family, deducting the interest on your taxes requires a significant mortgage. Possible to the point of being house poor.

Anyway, lots of folks have mortgage rates between 2% and 4%. If you are concurrently investing for retirement, carrying this type of debt over 30 years isn’t a bad decision. But if you are house poor, the mortgage nor tax deduction is worth it.

If mortgage rates climb back up to the long-term average of 7-8%, I’d pay it off. Finding an investment that would offset that high interest is tough.

Medical debt also falls here. I don’t know the interest rate on this type of debt, but the expenses are typically unforeseen and may greatly impact your health and well-being. So, do you best here and use reasonable judgement.

Bad Debt

I have pondered the rationale of the following for years and fail to produce a satisfactory rationale. So, if you have one of the following, handle it. These are toxic.

Credit card debt is among the worst. Specifically, not paying off your balance at the end of the month. Interest rates are crazy high. My card is something like 26%. Save yourself the interest by managing where your dollars go. Try filling out a budget. Here you go.

I might as well put this out there. No one became rich off the reward points, especially if you carry a balance.

Vehicle debt is the class killer. Absolutely hinders your assent of the socioeconomic hierarchy. Depreciating assets remove rungs out of the ladder used to climb the pyramid of financial success.

Don’t drive a vehicle to impress people at the stoplight that you don’t even know. And guess what, you do not impress them. They picture themselves driving your car.

New grads immediately upgrading their house and vehicle is a massive mistake. Absolutely lethal to financial health. There are ZERO reasons for a W2 employee or anyone with high interest debt to borrow money for a depreciating asset.

There are other ways to reward yourself for graduating aside from buying a $60,000 vehicle you can’t afford. When people reach out for financial coaching, this is one of the areas I look to immediately.

Credit card debt is usually under $10,000 and can be paid off in a month or two. Vehicle debt could be easily six-figures and takes a bit more maneuvering. It’s a hit to sell the vehicles because they are usually worth less than the loan amount.

But I tell you what, selling $120,000 worth of SUVs and buying a pair of 1995 Toyota Corollas is a quick way to eliminate $100,000 of debt overnight.

Then, work some overtime, pay off your debt, and save up for 6 months to buy your wife a 2023 4Runner in lunar rock with cash because it’s important to her. And she is your wife. Be sure to remind her that this investment is equal to each of us standing in the Black Rock Desert handing out $20 bills as kindling to every participant at burning man.

This is clearly not bragging due to the admittance of a significant financial setback -- Made tolerable by overtime, cash, and a delighted spouse.

Payday and family loans fall into the bad debt category. Payday loans are as bad as credit cards. Rates are high. Penalties are plentiful. Lenders attempt to keep borrowers on the hamster wheel of fees.

Family loans have variable interest rates but not worth it due to the relationship stress sited above.

Food for thought…

Rich people use debt.

Yep, they do. A well-known book on the topic is Rich Dad, Poor Dad from the must-read list. He speaks to financial success borrowing money for real estate properties that cash flow. It’s a highly leveraged strategy that has a great deal of tax advantages. And yes, many people have made their millions this way.

I deleted an entire 2-page tangent here. I’m just going to say that on paper, this approach looks bulletproof. Expect the unexpected because that’s where things go South, and you end up losing everything. It’s important to run the numbers realistically (conservatively) and only purchase with a high probability for success.

It’s not just about your tenant paying the mortgage. You have closing costs, interest on the mortgage, renovations, capital expenditures, maintenance, management fees, utilities, taxes, insurance, and vacancies.

Many wealthy investors made their money from buying foreclosed properties in 2009. Those looking to be aggressive leveraged their capital with the assumption that housing prices would rebound. The entire picture was prime for investing.

The same could be said for buying distressed companies and returning them to their former glory. Regardless, there will be more economic downturns if this is something you are looking to capitalize on. Be patient my friend.